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Get the Best Out of Active and Index Funds

In this 60-minute roundtable report, Morningstar's Russ Kinnel, Ben Johnson, John Rekenthaler, and Christine Benz dissect indexing's popularity, index versus active fund performance, and how investors can effectively blend the best of both in a portfolio.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Index funds have been gaining market share at the expense of actively managed products for the past several years. Joining me to discuss what the data say about active- versus passive-fund performance as well as how investors might hold the two together in portfolios is an all-star roster of thought leaders at Morningstar.

Russ Kinnel is here. He's director of fund research for Morningstar, and he also heads up the Morningstar FundInvestor newsletter. Ben Johnson is also here. He is director of global exchange-traded fund research for Morningstar. Last but not least, John Rekenthaler is here. He is vice president of research for Morningstar.

Thank you all for joining us today. This is a really important topic, and we're really excited to hear your thoughts.

Russ Kinnel: Glad to be here.

Benz: Let's start by talking about what we've seen in terms of fund flows. We've really seen tremendous flows going to passively managed products--both traditional index funds as well as exchange-traded funds. I'd like the panel's views on why investors seem to be preferring index products. Russ?

Kinnel: I think you're right. We really are looking at a more than 10-year trend of passive funds just continuing to gain steam, and I think it's partly that we've seen star managers come and go. I think people didn't like how some active funds [behaved] in bear markets. And I think another part of it is that it used to be the only people who were profiting from indexing were Vanguard fundholders, but then ETFs came out and, all of a sudden, fund companies and advisors had ways to attach their own fees to indexing and they could profit. And so now you see a lot more press, a lot more coverage, a lot more advertising around index funds. So, that's another part of it, too. Ironically, the addition of fees to indexing has led to greater popularity of indexing.

Benz: Ben, I'd like your take on the advisor's role in all of this. To what extent do you think advisors changing their business models has driven these flows into passively managed products?

Ben Johnson: I don't think you could [overemphasize] just how much the change in advisors' economics has influenced this trend. So, when you think about the all-in cost of advice, what you're seeing is sort of a squeezing of the balloon. So, as we move from transaction-driven models in advice channels to fee-based advisory models, what you're seeing is that the cost of the individual products is getting squeezed. You're seeing those costs, those expenses, manifest themselves in a fee based on assets under management, typically. So, what that has done is it's driven down the cost of the advisor's tool kit; they're looking for lower and lower-cost implements all the time, and that has benefited, disproportionately, index funds and exchange-traded funds.

Benz: So, you basically have advisors saying if there's only a fixed "fee pie" to go around, I want to make sure that I can get my piece and deliver the services [my clients need]. So, whatever the cheapest products are that we can use to populate the portfolios, that's what I want to use.

Johnson: That's absolutely the case. Also, I think what you're seeing is an evolution in terms of how advisors think about their value proposition. I think they're thinking more and more about the ancillary services--estate planning, tax planning. They're thinking more holistically about their relationships with their clients, and the advice--the investment-management component of that--is becoming increasingly sort of systematic and is being driven with an emphasis on, again, minimizing the cost of the underlying implements, in capturing value through all of these other value-added services, and not necessarily security selection, fund selection, or asset allocation, which are becoming increasingly commodified.

Benz: John, when you look at these flows that we've seen into passively managed products, to what extent do you think investors are responding maybe to performance? When you look at actively managed funds, Russ mentioned there are a lot of casualties--former star managers who have turned out to not be what maybe investors expected them to be.

John Rekenthaler: To a very large extent. We've known that mutual fund investors have always responded to performance. It used to be [that investors selected] active managers that had better numbers over active managers who had worse numbers, and that's how Fidelity became the largest fund company in the world at the time and, traditionally, how fund companies succeeded--by having actively run funds that had better numbers.

Before Morningstar ever existed--with performance numbers and star ratings and so forth--if you look [at the data], investors always bought, generally speaking, on long-term numbers. And index funds--in particular, in large-company U.S., which is the starting point for index funds, where most of the assets are--they have done very well, particularly in 2008. That year was huge for indexing because index funds kept pace with active managers in the big downturn, which is when people thought it would be active managers' relative time to shine. So, the trend was already moving strongly toward index funds; but I think, had 2008 played out differently, we could have seen the passive trend not to completely stopped but much slowed. Instead, 2008 accelerated it.

Benz: So, they didn't deliver in the clutch.

Rekenthaler: The active managers didn't deliver in the clutch. At least, that's how people perceive things, and that's how the story is told. That's where the assets are going.

Kinnel: There is kind of a footnote to '08: In equities, passive did just about as badly as active, so you really didn't get a lot of benefit. So, it wasn't a standout either. It was in bonds where passive did much better than active. Yet, what happened out of that was money rushed into active bond funds and passive equity funds, and it has continued to do that largely to this day. And yet, if it was really a performance story, what should have happened was that people should have been all over passive bond funds after '08 and equities wouldn't have really changed very much because the passive equity funds did just as poorly as active.

Rekenthaler: Yes, there are some quirks in the performance story. It generally holds true, but that's obviously one, and there are others.

Benz: So, what is going on in fixed income, Russ, in terms of the flows there? Despite that really good return from the Barclays U.S. Aggregate Bond Index in 2008, why do investors continue to prefer active products there?

Kinnel: Well, they did perform better after '08 because they tend to have greater credit risk and so on. So, I think that's part of it. You had Bill Gross and Jeffrey Gundlach as bond stars; if some of the equity stars were diminished, they were enhanced by what happened in 2008-09. So, I think that's part of it, but also I think people are just inclined to be passive with equities and not with bonds. So, I can't completely explain it.

Benz: I want to follow up specifically on bonds and bond-index construction; but Ben, before we leave the flows topic, I'd like to talk about what types of funds investors are tending to prefer when they're buying passively managed products. Where are we seeing the flows going?

Johnson: I think, for as much airtime is given to more exotic fare, what we see is most of investors' capital--where it resides now and, at the margin, where it's going--is going to very vanilla stuff, very broad-based benchmarks that are investable at an extremely low cost. That still accounts for the vast majority of all assets, all incremental flows into index funds, be they traditional open-ended mutual funds or be they ETF. So, again, I think what you see in the headlines--Russ alluded to the proliferation of advertising. If anybody watches CNBC--I can't bear to watch it--but if you watch CNBC, three out of four commercial spots are for some newfangled exotic ETF exposure. That's not where investors are putting their money. They're putting their money on low-cost plain-vanilla passive.

Benz: So, total stock, total international stock, total bond is really where we're seeing the flows go?

Johnson: Absolutely.

Benz: Russ, are there any areas--even though, overall, the trend is strongly toward passively managed products--where investors appear to be more comfortable sticking with actively managed products? You alluded to the fact that active bond funds have been doing a pretty good job of attracting investor assets.

Kinnel: For sure. Not just core bond funds, but really the whole array of bond funds--bank loan, high yield. We've seen almost all that is going to active funds. But also foreign equities--both broadly diversified as well as emerging markets--most of that money is going into active, though there are some strong flows into some passive foreign as well. It seems like outside of U.S. core equities, you see much more interest in active funds, in general.

Benz: Of course, it's hard to generalize about why investors might be doing what they're doing, but does anyone have any thoughts about why investors seem to prefer active products in the international space?

Kinnel: I think one thing is that, in international, you've long had overweighting in Japan in the indexes at least relative to active. Japan peaked around 1990 and, since then, has mostly lagged the other markets. And so active managers have pretty consistently added value by avoiding Japan; they tend to have more in emerging markets. So, they tend to have better return.

Rekenthaler: So, it is outperformance, Russ.

Kinnel: Fair enough.

Rekenthaler: To get back to my point--

Kinnel: In this case.

Rekenthaler: The foreign large-blend active funds, as a whole, have outperformed the passive funds. So, people do pay attention to performance. We can talk about why that is--[Russ] is talking about why that is--but yes, it's performance related. As well as habit. Because, as I said before, people started with U.S. large cap, S&P 500, as the first index. That just seems like the most logical and comfortable place to them, and the numbers are also supporting that as well. So, you've got performance and history working together. The performance and history are not as strong on the foreign side, and that's why the active managers are still receiving lots of money.

Benz: So, before we leave the flows topic, Ben, I'd like your take on whether this is really an ETF story or have we, in fact, seen flows go to the traditional index mutual funds as well?

Johnson: It's really been both. I would say the flows into traditional funds have been dominated by retail investors. I think if you look at the availability, given that ETFs are by definition traded on an exchange and the number of different use cases. So, if I am buying an S&P 500 ETF, I'm not necessarily using that as a core long-term building block; I might be a market-maker that's keeping that in inventory to hedge my exposures as I'm making markets in ETF shares. I might be using that more tactically to hedge some sort of exposure; I might be selling it short. So, if anything, ETFs have benefited marginally more, have seen additional flows only because I think the potential user base--from individuals to institutions--and the potential number of uses is greater relative to a traditional fund.

Benz: So, the short-term investor can find a home there, as can the long-term investor?

Johnson: Absolutely.

Benz: Let's look at performance. We've alluded to performance of active versus passive funds in various categories; but first, I would like to discuss why making an assessment about whether active management in a given area is good or bad is difficult to do. What are some of the impediments and what are some of the reasons? Just to use a simple example: Why shouldn't I go on Morningstar.com, look at the typical large-blend fund's return, and compare it with, say, some sort of total-market index? What are the drawbacks to a very simplistic assessment like that, John?

Rekenthaler: Well, there are a couple of issues with performance measurement. One is that the conclusion that you draw will differ depending upon the category--the area that you're looking at. For example, if you adjust for cost--so you just take funds with the same cost structure, eliminating the cost advantage index funds have--on the large-blend side, over all the trailing time periods, the passive funds have still beaten the active funds, as well as in small blend. So, both large- and small-cap U.S., for the same cost, the passive funds have beaten the average active fund. But if you look into the foreign large-blend funds, the opposite is true. If you look into the intermediate-term bond funds, the opposite is true.

So, of four major indexing groups, it's split--two versus two. Now, you're always better off buying the cheaper funds, so we need to start there. There are some expensive index funds that are not good. And there are a lot of expensive and overpriced active funds; I don't want those. But when you get to lower-cost funds or funds that level the playing field on cost, the evidence is mixed. And why is it mixed? Well, now we can talk for a long time because it generally has to do with some sort of difference in construction between the pool of active managers and what the benchmark is. We talked on the bond side about how the [Aggregate Index has] more in Treasuries. Internationally, there's--

Benz: More Japan.

Rekenthaler: More Japan. You go through the list, and there are all kinds of differences, so it's tricky to generalize because it ends up being not so much that a particular group of managers happens to be bright and another group is particularly dim, but that they're doing somewhat different things. And you need to decide whether you want to do that different thing or not.

Benz: So, I think fixed income is probably the perfect example of what you're talking about, John. Let's talk about how the Barclays U.S. Aggregate Bond Index looks pretty different from the typical intermediate-term bond fund, why that is, and what sorts of choices the active managers are making there. Ben, let's talk about that.

Johnson: I think if you look at the [Aggregate Index] as it stands today, it looks very different from [funds that use that index as their benchmark] in the intermediate-term bond category. And it looks fundamentally different because it leaves out what has been a very significant and very well-performing portion of that opportunity set that's available to active managers who aren't just trying to hew to that benchmark--which, in general terms, has been credit. So, if you look at the average manager in the intermediate-term bond category, they've been feasting on credit over the course of the past few years.

Benz: So, corporate bonds--

Johnson: Corporate bonds, anything with more credit exposure than you might face relative to something issued by the U.S. government.

Benz: Right.

Johnson: You look at [the Aggregate Index], and it's very heavy on securities that are either directly issued by the U.S. Treasury or have some sort of implicit backing from the U.S. government. So, that has really disproportionately benefited--at least, in hindsight--the active managers in the intermediate-bond space because they have an active mandate. They can go virtually wherever they'd like, depending on what their process is, what their actual mandate might be, whereas the index funds have to hew to the index.

Now, if you look at [the Aggregate Index] and widen it out, so if you look at the Barclays U.S. Universal Index, which tacks on a portion of that credit pool where active managers have been playing, it's been a much higher hurdle for that same category. So, from an investor's point of view and an index investor's point of view, that's fared relatively favorably. Of course, we're talking about the since-2008-09 portion of this cycle. Things are going to look fundamentally different the next time we go through a downturn, whereby it's not going to pay to necessarily have that credit exposure the next time global markets hit the skids.

So, it's important, I think, more than anything, as an index investor, to understand the benchmark because there is a process underlying that benchmark. Does that benchmark adequately reflect the opportunity set, the constraints that might exist for active managers? Where it does reflect that opportunity set, it's going to be more difficult to beat. Where it's either narrower or more concentrated in certain cases--something like the MSCI EAFE--it's going to be easier to beat because, by virtue of omission, I can say, "Japan's not my taste right now; I'm going to sidestep these things." And it represents a very heterogeneous group of exposures, of countries, of sectors, and so on. So, understanding the benchmark is absolutely vital.

Rekenthaler: One of the biggest advantages that active managers can deliver is not what they buy, but what they avoid. And we've seen that several times in the past where active managers have fared the best when an index will have a chunk of something--as in Japan or as in technology stocks--that tends to be highly priced, in the headlines a lot. And active managers are saying, "I don't want to make that complete bet." That's when they've done well. But if the index doesn't have those opportunities in it, it's harder for active managers to go security by security, [identifying which ones to buy or not buy in order to beat the index].

Kinnel: In the bond world, I think it's also a good portfolio-planning idea, too. You say, "OK, this index fund is giving me almost all government exposure. Some of these active funds are giving me something very different." And so, part of it is just understanding what kind of exposure I want there. A lot of the active funds have huge tool kits.

This year, PIMCO Total Return (PTTRX) is ahead of the group because they bet on the rising dollar. DoubleLine has historically made a lot of hay by investing in mortgages, even private mortgages. Funds make all sorts of derivative bets on, say, yield-curve moves, sector moves. So, you've got, on the one hand, a really wide-ranging tool kit and, on the other hand, with passive, a very government-heavy, high-quality [portfolio], but with some interest-rate risk. And so, really, you've got two fairly different things together in the same category.

Benz: I think that's a really interesting point, Russ. And I guess when you look at the fact that investors appear to be preferring active funds in fixed income, are they perhaps overlooking the fact that the Aggregate Index might be pretty narrow? Though, it sure did come through in the clutch.

Rekenthaler: It's the better hedge in an equity downturn, I think. You could never say that with absolute certainty because each downturn has different characteristics and the correlations that happened last time won't exactly match, but it's a pretty good bet that [the Aggregate Index] is going to be a good hedge against a stock market downturn--and better than most of the actively run funds because of that Treasury component.

Benz: OK.

Rekenthaler: So, it comes down to portfolio role. Is it more important for me for this to be a hedge during that downturn or more important for me to make a little more money in this area over a five or 10-year period? You're probably going to get more total return when you have the active funds that have more credit in there, but it will sting a little bit.

Johnson: It's important to have that context, too.

Rekenthaler: Right.

Johnson: We're not talking about selecting funds, selecting benchmarks in isolation. [You need to] take a step back and think about the overall asset allocation and what does that yield in the context of the overall portfolio and the risk/return profile thereof.

Rekenthaler: And if I could push a point just slightly further: If you think about those roles, you say, "OK, if this is really about correlations and hedging, I'm going to move toward more Treasury-heavy. If I'm willing to live with a little bit more pain in the downturn than the active funds and if I'm really not that concerned with it, I might not own that bond fund at all"--which is more of the way I go, which I'm not advising everybody to do. But I'm not the only one who has made that [decision]. There's Bill Bernstein--some others. At any rate, you want to think about the role that these things have, and that will end up informing your active/passive decision often.

Kinnel: How big is your fixed income as part of your overall portfolio? If it's 50% of your portfolio, then I want the BarCap, I want some of these more aggressive managers. I'm going to want probably some foreign bonds, maybe some more yield. I'm going to want TIPS, for sure. I'm going to want a really broad array of a diversified bond portfolio. If it's 10% [of my portfolio], then that diversification is a little less important.

Benz: So, we've talked about how it's really crucial, before you make these active-versus-passive performance comparisons, to understand how the index may be different from the universe of active funds that you're looking at. I'd like to also talk about time period--how that matters and how that informs some of these trailing returns that we might look at. One thing I've heard loud and clear is that, in a really robust market environment for the stuff that's in the index, the index fund will be the winner. Let's talk a little bit more about how time period plays a role here. And, Ben, maybe you could hop on this--talk about how, looking at equity passive products today, they may look a little stronger due to the fact that we've had such a strong equity market.

Johnson: I think it's important to go back further yet, and I think the longer you look back, the more the case for index exposure is galvanized looking across full market cycles. And let's not conflate that necessarily with passive so much as, first and foremost, it's a matter of cost. And when I speak to the topic of cost, you've got to think more holistically and think also beyond the headline expense ratio. Think of all of the other implicit costs of day-to-day portfolio management. And when you look at, say, a total U.S. stock market index, the annual turnover in that index is 3% to 5%. And there's a real cost to turnover in terms of brokerage commissions.

In the context of an active manager, every time you're turning over your portfolio, you're making a call. So, you're saying, "I have conviction in this"--whether I'm buying or selling. So, not only are there those explicit costs, but there's the implicit cost of potentially being right or wrong. So, the higher your turnover, the more you're incurring both those explicit and implicit costs. So, long periods of time show that low costs--be it the explicit fees, be it portfolio turnover, taxes, what have you--are absolutely critical, especially in the context of where we're at in the current market cycle, where everybody's drawn down their deferred tax assets and now they're spitting out big capital gains. These all add up over time. So, it's not passive so much as that passive implies low costs in the form of low fees, low turnover, and less of a tax headwind. So, passive just has shorter hurdles ahead of it than active--where managers often create hurdles for themselves.

Benz: So, Russ, I know that you have written and worked a lot on this issue. In fact, it's your view that it's not active or passive, it's low cost versus high cost--and you can find some low-cost active funds.

Kinnel: Right. I think when you look at a really well-run, low-cost active fund, now you're talking about a fund that's maybe charging 40 or 50 basis points versus the index, which is charging 15 or 20. Now, you've got a much lower hurdle and, often, very good funds. You look at some of Vanguard's actively managed funds, and these are outstanding values, where they only have to beat that hurdle by a small amount. So, I do think, yes, you want low costs in either case. John wrote a column about a year ago where he looked at the biggest funds from a decade ago and found that those active funds did quite well, too, because nearly all of them are low cost--because the big funds tend to be low cost. So, I think if you get your plan right and you're a patient investor and you buy low-cost, well-run funds, you're going to do well, whether that's mostly active or mostly passive.

Benz: Ben, you have been keeping tabs on data about active versus passive performance over various time periods, and I think we've alluded to some of the conclusions so far. So, large-blend funds versus, say, a total-market index over almost any trailing period, as John said, are not super overwhelming in terms of performance. The active funds haven't done very well. Foreign funds have done relatively better--is that what your data would indicate?

Johnson: So, I think what we've seen is what others have already documented in other research that's been conducted: In more efficient markets, such as U.S. large caps, it's more difficult--and I would argue that it's probably getting more difficult by the day to add value to outperform. If you look at other markets, depending on how you measure it, whether relative to benchmark, whether relative to passive investable alternatives, for all the reasons we discussed earlier, your odds are more favorable in terms of outperforming either a passive option or a category-relevant benchmark.

Fixed income is another area, for reasons we discussed earlier. The odds have generally been more favorable for investors in terms of being able to select market-beating alternatives to passive options. A lot of that has to do with the construction of bond benchmarks; a lot of that has to do with just the nature of bond markets. Bonds are not stocks. So, it's a different set of use cases. It's a different set of criteria. It's a different set of investors relative to stock markets.

So, uniformly, what I would say we see across the data that we've looked at, again, is that it underscores the importance of cost, first and foremost. So, as you separate performance by cost quartiles and look at the lowest-cost fourth of funds across virtually all categories, your odds improve materially as you shop for less- and less-expensive funds. And that's as defined not only by the headline expense ratio, but also by turnover as well, which yields implicit and explicit costs, and in tax costs as well.

Rekenthaler: Vanguard's passive equity funds and its active equity funds have had similar aggregate long-term returns because their active funds are cheap.

Benz: OK.

Rekenthaler: So, that's the bigger consideration. We're all saying the same thing, but it really is true. We've kind of framed it as passive versus active, but really it's low cost versus high cost. That's what it ends up being.

Benz: Right. So, the data on this will tend to swing around based on time period, based on composition of active portfolios, but I'd like the panel's take on the question, "Are there any areas where you would say absolutely always index this area? And on the flip side, are there any areas where you would say never index--it doesn't make sense?" Russ, how about that?

Kinnel: Well, there are some areas where there aren't a lot of index options--high yield, emerging-markets debt, munis. There are a few funds out there, but not a lot. But, in general, I like to use index funds to lower my overall portfolio cost, to free-up some of the active managers. If I've got broad index funds in my portfolio, then I don't have to worry about having all of my active funds fit in perfectly together. I've got some room. I think it's strange that people completely write off large-cap U.S. actively managed funds when you look at how many really good ones there are. I own a couple of Primecap funds that are in that space. They are outstanding funds. I don't know why I would want to sell them.

Sequoia (SEQUX) is now closed, but that's another great one; Oakmark Select (OAKLX); Vanguard Dividend Growth (VDIGX). There are so many good ones; I don't why you'd want to rule them out. So, I think, for me, it's more about getting really broad, lowering your costs, and then picking your active funds where you find really good ones.

Benz: Ben, what's your take on that question? Are there any areas where you would say always index or never index?

Johnson: I think if you look at U.S. large caps, I wouldn't say always index, but I would say, certainly based on all of the data that we've seen and I think increasingly on a go-forward basis, these markets have become hypercompetitive at this point. There is now in excess of 100,000 CFAs globally. We'll all soon have Apple devices on our wrists. The informational efficiency, the degree of competition for outperformance for alpha in something as broad and liquid as U.S. equities is only going to grow over time, which means that everyone's more skilled and the distribution around average performance is going to get narrower and narrower.

So, the benefits for selecting a good manager are going to be less. Conversely, the benefits for selecting a crummy manager are going to also be less painful, I would expect, over time. But I think U.S. large caps, in general, I would focus the majority of that sleeve to a benchmark and then think about carving out an allocation to a high-conviction active manager. I think Russ has provided some great examples there.

Benz: A follow-up question, Ben: We've written and talked about this before, but this issue of increasing flows toward passive, is that potentially going to create opportunities for active managers? We go back to maybe the tech-stock mania, for example. All the indexes are sort of blindly buying these companies--that was actually a great opportunity for value-oriented managers. Would we see, potentially, that sort of phenomenon occur again in the future?

Johnson: I don't want to draw the conclusion that indexing is necessarily changing market movements. I think we're in a macro-driven world right now, where [quantitative easing] has become dinner-table conversation for a large segment of the population. So, markets have been whipsawed by Fed-speak, not necessarily by ETFs. ETFs and index funds are just looking to track the benchmark. So, I think what creates opportunities for active managers is not correlations amongst components of the equity market, it's dispersion. The biggest gainer and the biggest loser--how wide is the difference between that? Because, as an active manager, that reflects my opportunity, my capacity to outperform, by either avoiding really big losers or buying really big winners.

When that's narrower, as we saw last year--2014 was a prime case of this--that dispersion was extremely narrow and active managers had a terrible year, because that opportunity set was very narrow. So, it's dispersion that creates opportunities, but you also can't jump to the conclusion that active managers are always going to capitalize on those opportunities. Some will; some won't. And the wider it is, the wider the differential in their performance. So, it's difficult to say.

Benz: John, do you have something to say on this topic?

Rekenthaler: I'm ready to say always and never.

Benz: Always?

Rekenthaler: Well, OK. I have to slightly asterisk this because it's fairly close to always and fairly close to never. We'll go there.

Benz: Always index?

Rekenthaler: I'm going to start with never, which is a hedged never; but as a general rule, if I were looking, I don't buy sector funds and country funds and narrow funds, but if I did, I would be reluctant to buy an index fund because the construction of the indexes, when you get into single countries, have some strange properties. Unless it's a really big diverse country, or sectors or whatever it is--infrastructure or just narrow chunks of marketplace.

Benz: You get some weird indexes with high concentrations.

Rekenthaler: I've seen indexes with 18% or 22% Finnish stock market and such. So, I would look for a respected, good-quality fund company offering an active fund at a reasonable cost. And even if that didn't have much of a track record, I would bet on that over an index. And I would think that the odds are good that if one segment of that concentrated market is acting peculiarly, then the manager is going to lower risk by avoiding that.

Benz: OK.

Rekenthaler: So, that's [an instance where I would] almost never index. [When it comes to the question of where should you] almost always index, I would just say--somewhat in contrast to Russ--on large-cap U.S. in a taxable account. The odds of identifying a fund ahead of time and taking taxes into consideration--there's probably a handful of low-turnover large-cap managers still at a low cost who are active, who are competitive. It's a small number. I think, for most people, the argument is pretty simple; just to go out there and index. Or you could buy some Berkshire Hathaway B shares (BRK.B); that's like a big mutual fund at a low cost, too.

Benz: I want to follow up on this tax-efficiency point. We could spend a lot of time here, but I think when you look at the data, if someone is within a taxable account, there are strong advantages to being in some sort of a passive product. To what extent should other sort of personal characteristics--my tax position, for instance, but maybe more sort of personality characteristics--inform whether my portfolio is majority active or majority passive? Russ, I know you have some thoughts on that.

Kinnel: Well, one thing passive funds do is they give you time. It doesn't take as much time to research them. Not a lot of changes, so if you're someone who doesn't have enough time or you tend to make changes because some big event has happened, maybe you haven't been paying attention to your investments for a couple of years and now something big has happened--either a macro event or the manager has left--and you kind of panic and make a bunch of changes, in that case maybe passive is better for you. I think, in either case, you need to be patient.

With active, it requires maybe another level of patience, because you have to understand that there are going to be times when you'll lag the benchmark, when you'll be out of favor. You really need to hold that fund for the long term. So, I would say that's maybe a little diagnostic of the personality that's the best fit for active.

Benz: The best active funds will tend to look really bad at certain points.

Kinnel: That's right. We talked about star managers. One of my pet peeves is that we've seen funds like the former Legg Mason Value under Bill Miller and others lionized for beating the benchmark every year, and people then think, "Well, that's what I want an active manager to do." People think they're somehow going to miraculously out-think the markets every single year.

Rekenthaler: On an arbitrary calendar--why not to do June to June? That's a fiscal year.

Kinnel: And that's setting you up for tremendous failure. That's not what active managers can do well. It's much more about finding good values that, over time, pay off. And so, you really do need to be a patient investor and have the right expectations going in. You can't think, "This manager's got to do well every year." Or we talked about '08: One of the things some people said was, "Well, this manager should have gone to cash or they should have gone into bonds." And that was even for funds where the fund always was in equities; maybe its prospectus didn't say it would go into cash.

So, you have to be realistic as well and understand what the manager will do and what they won't do before you buy the fund. Look at the fund's calendar-year returns. Understand what you're getting into ahead of time.

Benz: So, investors often compound their problems with active funds, too, by buying them after they've had one of those great performance runs?

Kinnel: That's right. Another part of that is you have to be a rational thinker who can keep contributing even in a downturn and not just go after the hot fund that had a good single year, or else you're just setting yourself up for failure.

Benz: One thing I wanted to touch on regarding performance: We have our investor-return statistics where we can look at dollar-weighted returns, see how the typical investor in a given fund has done. What do the data show when we look at active versus passive products? Do passive investors tend to do better from that standpoint?

Kinnel: A little better. It kind of depends how you look at it; but in general, they do a little better. It's a very time-period-dependent measurement because--

Benz: Investor returns?

Kinnel: Investor returns are because you can have, say, an event that happened 10 years ago--maybe a lot of money came in or maybe, when we look at some share classes, maybe a new share class was created and that can throw the data off. So, I'm cautious about reading too much into it, but I think, over the long haul, we'll find they do a little better because they tend to invest consistently.

Rekenthaler: Let me touch on investor returns. So, investor returns is an attempt to measure how investors are doing in funds--are they making wise investment decisions?--and separating that out from the standard fund returns, which are calculated no matter what dollars are in there.

Benz: Right.

Rekenthaler: So, if you look at investor returns now, they tend to look quite good for passive funds. Why is that? Well, there's been a lot of money that has come into passive stock funds over the last five to six years, and the stock market has been up a lot. So, I'm speaking about U.S. stock funds right now. So, the money has come in; this new money has never known a down year, if it came in after 2008. It has done well, so the investors look smart. Setting aside that maybe the funds that they're buying are good funds, are passive investors smart in the sense of a market call? No--it just happens that the people who are buying into the market in the last few years have decided to invest passively rather than actively. If we have a big downturn next year and the market drops 25%, then all of a sudden, the passive-investor returns are going to look not as good--maybe even fall behind the active-investor returns because a lot of money has come in recently. So, when you're interpreting these numbers, it's just difficult to [come to a definite conclusion]. We keep talking about how much work it is, but it is a lot of work. You look and you draw a simple conclusion; you say, "OK, passive-investor-return numbers are good right now. Passive investors are making much smarter asset-allocation decisions." Well, the next year, in a different market, the numbers tell you something different. It's easy to arrive at a simple conclusion, but that doesn't mean it's a correct simple conclusion.

Benz: Right.

Rekenthaler: There are many ways of coming to an incorrect simple conclusion.

Johnson: And I completely agree that there are flaws with these numbers. It's important not to take them at face value. But Russ touched on the topic of expectations before. So, intuitively, an investor in an actively managed strategy comes with the expectation of outperformance over some period of time. An investor in an index fund expects market performance. So, to the extent that that could potentially drive relatively better behavior, as it were, I think there's some intuition there. I'm not necessarily relying on the numbers--

Rekenthaler: I think passive funds are easier to own. I think, as a general rule, investors will have a better investor experience, as we define it, which is the gap between investor returns and the standard returns. They will have a better experience, in general, with passive funds because it gives them fewer reasons to make a bad decision. If somebody is liable to make quick decisions based on short-term data, buy passive funds and avoid that temptation. That's a temptation that will lead you down to a hot place somewhere down there. If you're an investor, you don't want to go there.

Johnson: But those same people probably aren't willing to settle for market returns at a low cost and watching paint dry across markets--

Rekenthaler: Well, no--what they're doing is they're buying those new ETFs that you [see commercials for on] CNBC.

Kinnel: That's right.

Rekenthaler: You can get the best of both worlds. It's active-passive.

Kinnel: Maybe the most active investors out there are the people who are buying niche ETFs and trading them every six months.

Benz: I just was talking to our colleague, Tim Strauts, about where the flows are going in terms of ETFs, and the hedged international funds are seeing huge flows. So, maybe that's an illustration of what Russ was talking about.

Johnson: Yeah.

Benz: I want to talk a little bit about a fund type that's kind of a hybrid--the strategic beta products. Ben, maybe we can start by you just defining what strategic beta--sometimes called smart beta--what the heck that means.

Johnson: What you're seeing, really, is an evolution in index construction. So, the Dow Jones Industrial Average, the BarCap Aggregate, they were designed to be printed across the masthead of the Wall Street Journal. They were designed as a broad barometer to gauge the performance of a big sloshing bucket of securities. What you see in strategic beta is the emergence of indexes as an investment strategy that combine elements of active investing. So, all of these involve some sort of active bet relative to a broad market-cap-weighted exposure, while trying to retain many of the benefits of passive investing. So, they tend to be relatively low cost. They tend to be transparent, rules-based. All in all, most of these look to exploit some sort of factor, some sort of returns.

Benz: Let's talk about some examples of factors.

Johnson: The factors are factors that have been documented for years and years and years in academia. They're factors that people have been trying to exploit for years and years and years in asset management. What we're talking about is old wine in new bottles. DFA has been doing factor investing now for decades. Barr Rosenberg, founder of BARRA [Barr Rosenberg Associates], was talking about his bionic betas in the mid-1970s, around the time the first index fund was launched. So, this is nothing new.

Johnson: Any name you like. I prefer strategic because it represents an investment strategy. So, I'm looking to isolate value. I'm looking to isolate maybe some sort of size premium. I'm looking to isolate dividend income.

Rekenthaler: Momentum.

Johnson: Momentum, quality.

Benz: Liquidity.

Johnson: Liquidity. It has grown exponentially, and now they're being recombined in multifactor exposures. So, it's old wine. It's these old factors that we all know well that have been documented, that have been exploited before, but in new bottles--in an ETF package. It's traded on an exchange; it's broadly available.

Rekenthaler: I think it's important to also mention that these are the kinds of things active managers historically have done. So now, you have these funds that are actively built but passively run. Passive funds are competing on what used to be only active managers' territory. Back in the day, if you were an active manager and you had some value and momentum exposure, maybe not even consciously--

Benz: There are still funds that do that.

Rekenthaler: Maybe not even consciously thinking of it that way. You just bought companies that had those attributes, and you probably had above-market returns. You got a lot of money. You were a great active manager. Now, that can be possibly, in some cases, fully duplicated through a mechanical strategy.

Kinnel: I love how it raises the bar on active management. You can look at equity income. There are equity-income indexes and equity-income funds and you can say, "OK, let's look at that passive index and compare equity-income funds and see which ones meet this higher bar."

There's dividend appreciation--Vanguard's got a fund for that. There's some momentum. So, what I really like is that [these new strategic beta funds] raise the bar. It's a little easier to see which ones are really adding value, but it also means you've got this fallback option of a lower-cost, passive version--and particularly for a dividend fund, that means more of those dividends are flowing through to me. So, I think [strategic beta funds] overmarketed, but there's also some really good value and some really good ideas in those.

Rekenthaler: It's great competitive pressure on the active funds, because now you've got something out there at half or a third or a quarter of the cost that is overlapping a lot with some of these manager strategies.

Benz: So, if you've got an active fund that's using some really mechanistic strategy, the fact that there is this index with a very low price tag attached to it potentially puts some pressure on it.

Rekenthaler: It's even more than that. There might not be a mechanistic strategy, but it might be that the idiosyncratic bets that they make balance out; some work, some don't. So, what you end up with is a mechanistic return minus the cost. And you might as well get a mechanistic return minus a lower cost and also an easier to research, more predictable fund through an ETF. So, these are a second wave of challenges for active managers.

Johnson: And I would say there's incremental idiosyncratic risk--something like manager risk and key person risk and personnel risk--at an active shop as well. So, you eliminate that element in addition to offering exposure at a very low cost. We see some examples where you look at the strategic beta tack and you look at an active strategy, and the performance differential in certain cases is exactly equal to the difference in the headline fee. So, it's just a lower hurdle for a very comparable strategy.

Rekenthaler: Since we are being nice to just strategic beta, to be un-nice, I don't think people are going to use these well. Instead of being used strategically as a 10- or 15-year long-term portion of the portfolio, they're going to go in and use these things like sector funds and make the mistakes people have traditionally made with funds and buy the strategic betas that have done well recently and sell the other ones.

So, I would be surprised--especially when you look at the more specialized funds--if they end up really making money for people, even though they're well constructed in many ways. We said the positives. But that's the drawback.

Johnson: And you already see that, in terms of how investors are selecting these funds. If you look at the U.S. universe of strategic beta ETPs, what we see is a pattern of behavior whereby 80% to 90% of the incremental flows are going into funds with a Morningstar Rating of 4 or 5 stars--

Rekenthaler: Which means that the past performance has been strong. That's how the star ratings work. Just to be clear, it's nobody's opinion; it's just that the funds have had strong numbers. People are performance-chasing.

Johnson: That's exactly the case. So, I would expect--to your point, John--that in all likelihood, [investors] will use [strategic beta funds] every bit as badly as they have active managers.

Kinnel: Right--because, of course, the academic research underpinning all of these generally would tell you to do the opposite. To buy momentum after it's done poorly. So, yeah, I think we will have this sort of immature phase for a few years in which they'll be used badly. They don't have to be used badly. I like some of the low-volatility strategies, some of the dividend strategies--especially when they come with the Vanguard-brand expense ratio. And so, I think there are some appealing funds, but yes, unfortunately, not everyone is using them correctly.

Johnson: As you alluded to earlier, Russ, with active strategies, expectation-setting is critical. Value pays off over the long term, but the long term is measured in tens of years, and not tens of months. So, it's crucial--much as with a disciplined active strategy--to ride through the good and the bad and understand, over the course of the full market cycle--which, again, is probably in excess of 10 years--that you'll be compensated for that particular strategy in the form of outperformance. But as we've seen--and you've documented in your "Mind the Gap" study--very few people are willing to ride out those the storms.

Benz: Russ, you mentioned a couple flavors of these funds--low volatility, some of the dividend-focused funds. If I were inclined to use one of these products, how would I use it in the context of my portfolio? Do I use it alongside a total-market index? Do I use it instead of a total-market index? What's my plan there if I were inclined to use a fund like this?

Kinnel: You might use it instead of [a total-market index] or it might be a supporting player. I think of Vanguard Global Minimum Volatility (VMVFX)--I think I'm getting that name right. But anyway, that one is essentially indexing the world, only it's got a currency hedge and it's got some other biases to reduce the volatility. So, that one you could use as a replacement. Then, others like, say, an equity-income fund or a dividend-appreciation fund, you might use in addition to [a total-market index]. And then there are some others that are more niche like a momentum fund, which is very much one you'd use as a supporting player. I would hate to see someone swap out a total stock market for a momentum fund--that would not be good. So, I think, some of them, yes. More of them are kind of somewhere in-between niche and core.

Benz: Ben--Russ mentioned a couple of Vanguard products in this area that he likes. Are there any other strategic beta products, or shops that are doing strategic beta, that you think are doing a particularly good job?

Johnson: So, there are two funds in particular. One could be used either as sort of a core player or specifically as a way to generate equity income. Schwab US Dividend Equity ETF (SCHD) charges an extremely low expense ratio and tracks a benchmark that has a very fundamentally sound methodology underlying it that isolates quality dividend payers--so, dividend payers that have grown their dividends across market cycles and haven't cut them nearly to the extent that other dividend payers have during market drawdowns. It's a very high-quality portfolio; it's a value portfolio. That's the other bit, too, to understand is that the way these things are labeled and their process and what comes out in the wash in terms of the end product--there is often a differential there. So, a lot of the dividend strategies are really just value strategies with a dividend label put over the top of them.

Rekenthaler: A lot of strategic beta strategies are value--

Johnson: Going small, going toward value--

Rekenthaler: You just shake it around and you end up with a value portfolio.

Kinnel: And that's key. You talk about core holding versus [supporting player], and building your portfolio; if you're buying one of these fundamental index funds, understand that it's filling the value role in your portfolio.

Benz: Use our X-Ray tool.

Kinnel: Right, use our X-Ray tool, and make sure you're not taking on undesired sector bets.

Johnson: And make sure you are not paying too much for a type of exposure that you could get in a very low-cost, very straightforward manner elsewhere. Why go the strategic beta route for 50 basis points to pick up a little bit of size and a little bit of value in your portfolio when you could buy Vanguard Small Cap Value (VISVX) at a fraction of the cost in a far more straightforward, transparent way. So, it's important to understand what you are really doing, not only in terms of overlap, but overlap from a factor perspective, too.

Rekenthaler: If you notice what we're doing is we used the strategic beta funds and held the active managers against them and said, "Are you getting enough value?" Now, we're doing the same thing for the strategic beta funds. Hold the more-general, lowest-cost funds against them and say, "How much difference is there? And is it worth paying extra for?" So, do to [strategic beta funds] what they're doing to others.

Johnson: There are a lot of ways to skin a cat. Do I want to take the more expensive, more convoluted route necessarily? I would argue that's not necessarily always the best route.

Benz: So, it sounds like you had one more pick for us, though, in terms of strategic beta?

Johnson: The other one in terms of U.S. large-value is PowerShares FTSE RAFI 1000 (PRF), which follows Research Affiliates' fundamental index approach, which is really a value strategy, but it's a value strategy that is somewhat more volatile in that it rebalances into value pretty aggressively during market downturns based on an assessment of company fundamentals. It's available at a very competitive price tag, and it has fared very well relative to strategic beta, relative to vanilla beta, and relative to active managers in the U.S. large-value category.

Benz: I want to get to some specific picks within the active and index space. But before we get into, say, our favorite index funds--and we've talked about some of them--let's just tick off a few know-before-you-go things. For instance, look for low costs, understand the index's construction. Is there anything else that investors should have in mind when they're trying to decide among index funds or decide whether index funds are right for them?

Kinnel: Let's see. Certainly, holding period is another part of that--

Benz: Your holding period or the fund's?

Kinnel: Your holding period.

Benz: OK.

Kinnel: So, you want to align that correctly. I think you want, as you mentioned, low cost. You want to think about the taxable side. If you're buying a passive fund, maybe put that in your taxable account. And put the active in your tax-sheltered account.

Benz: So, in terms of favorite index products, several have been mentioned during the course of this discussion. While we're talking about costs, I know that our ETF analysts really like a lot of the Vanguard funds, specifically, because they are lower cost than some of their competitors. Are there any reasons that investors might look outside of Vanguard?

Johnson: I think there are a number of different reasons--chief among them is choice. So, Vanguard has a very concentrated lineup of ETFs, 66 or so ETFs, which are uber-low-cost, broad, core portfolio building blocks. If investors are looking for more-nuanced exposures, if they're looking to hedge currencies, get some sort of more narrowly focused low-volatility strategy, they're going to have to go outside of Vanguard to meet those needs. So, there are any number of those sorts of exposures.

One that comes to mind would be iShares MSCI Emerging Markets Minimum Volatility (EEMV), which is something Vanguard doesn't have a comparable offering for. They have a broad-based FTSE emerging-markets ETF index fund. But certainly, there is a whole host of offerings outside of Vanguard's walls that offer very useful and very competitively priced exposures.

Benz: So, if for whatever reason you were inclined to slice and dice things a little more narrowly, you may have to look outside of Vanguard?

Johnson: Right.

Benz: Let's talk about active products. I think we've hit on some of the things you should think about before you embrace an active product--[for instance,] knowing yourself and your ability to withstand some of those periods of turbulence, knowing how your fund is positioned is obviously very important, tax character of those assets is also an important consideration. Any other things you would add to that list of things that investors should have in mind when looking among active funds?

Kinnel: Among active funds?

Benz: Yes.

Kinnel: I think you want all of the good characteristics you mentioned. I think a good strategy is important; stability is really important. We talked about all the great benefits that stability in passive brings; but I think [in active] you should look for a stable team. I like Dodge & Cox; I like Primecap. Some of the Wellington funds run for Vanguard. Those are firms that have tremendous stability, and that makes the funds easier to own; but it also makes them better long-term bets because they are better designed to carry on over the years. You're not so linked to a single manager. These are firms with really strong cultures, which means they're going to be very good stewards. They are going to do the right thing for you.

Rekenthaler: They are often going to be partnership structures--partnerships or something closely held.

Benz: Not a publicly traded firm.

Rekenthaler: Yeah, generally speaking, you'll have more success. We've looked at that, and the numbers are better when you don't have these external pressures and the profits each year and somebody thinking of the unit as a cash cow. Running mutual funds is a cash-cow business, but you don't want your owners thinking of just having that expectation.

Kinnel: [You want to make sure the management company is] good at attracting people and it's good at retaining people, but it also provides a mechanism for passing on ownership to the next generation as opposed to selling out to the highest bidder and then watching everyone flee.

Benz: So, the stewardship question in a lot of ways.

Kinnel: Yeah, stewardship is very important. Really, you want to know that fund company and make sure that they are a leader in stewardship and in really doing the right thing for investors.

Rekenthaler: You are buying into an organization, not just buying a fund--think of it that way.

Benz: So, John, let's talk about some firms or specific funds that you think kind of epitomize that steward role.

Rekenthaler: Well, Russ mentioned--

Benz: Primecap, Dodge & Cox.

Rekenthaler: Yeah, Dodge & Cox. They are familiar names. American Funds as well, even though they've been unpopular in recent years in terms of asset flows. They've done a great job, and their funds have still been performing well.

Kinnel: Tremendous stability. The analysts and managers make a career of it there.

Rekenthaler: The funds can be active or passive, but organizations with long-tenured employees. DFA is another organization. It's hard to get DFA funds. You need to go through a DFA advisor, so it's a little bit of a different path. But if you want to talk about a company that was an early [adopter] of strategic beta and has been right on a lot of things and has run their funds in a very consistent way that's been easy for people to own. That absolutely fits there. So, you've got anywhere from Vanguard representing--although it's not all they do--sort of pure traditional indexing to strategic beta people to active managers. Honestly, that's how we tend to think of things: high-quality organizations with stable people offering good investments. From there, you can get down into this kind or this kind or this kind [of fund]. But it's really about good organization or not so good. Good, mediocre, or bad. I think that's our starting point for thinking as investors within Morningstar.

Johnson: And there are commonalities there that span active and passive, right? So, you were talking about good stewards of shareholder capital, ones that have a direct alignment with their investors' outcomes, you're talking about low cost--

Rekenthaler: Usually, good communication. So, you know what it is that you are getting and not getting surprised.

Johnson: Low turnover, which is reflective, I think, of a long time horizon--not just at the level of the individual portfolios, but at the level of the business at large as well. And that all creates low hurdles for success, be it a passive strategy or be it an active strategy.

Kinnel: The fundamentals are the same. Even competitive advantage, which you think mostly is on the active side, but it's the same as passive: You want costs or a competitive advantage, as well as the way the index is built. So, I think all those things really do apply. Again, if you're doing a good job on identifying those fundamentals and you're investing for the long term, you're going to do well either way.

Benz: OK. We have discussed a lot of different topics. I want to thank each of you for being here today; you've all provided terrific insights. I know that our viewers have much benefited from them. So, thank you so much for being here.